Federal Reserve and Monetary Policy

1. Amount of money in economy determines amount of spending

• Too much = inflation • Too little = recession

Fed manages money supply by…..• Influence lending among banks and other

financial institutions

2. Monetary Policya) Expansionary = expand credit, MS, growth

(easy money)b) Contractionary = restrict credit, MS, growth

(tight)

3. Three Tools a) Open Market Operations (Federal Funds

Rate)b) Discount Rate c) Reserve Requirement

4. OMO - Most useda) Fed buys and sells US government securities-US Bondsb) Expansionary- buy bonds- Fed buys $1000 bond from Joe- Joe now has $1000 = increase in MS c) Contractionary – sell bonds- Fed sells $1000 bond to Joe- Joe now has a bond but $1000 less in cash =

decrease in MS

• (pg 1 ; last two paragraphs) Fed’s affect on INTEREST RATES Intro to Money Market Graphs (text 736,738,741)a) Expansionary ; buy bonds ; increase MS ; decrease IR

Int Rate

Q of Money

MS 1 MS 2

MD

b) Contractionary ; sell bonds ; decrease MS ; increase IR

MS 2 MS 1

MD

• (1st page ; last paragraph and 2nd page ; first paragraph)

Federal Funds Rate (What is it?) a) Federal Funds – reserve balances of financial

institutions held at 12 Regional Fed Banksb) If a bank can not meet its “reserve

requirement” – it can borrow reserve funds from other banks

c) FFR – the interest rate banks pay when they borrow from each other

5. FOMC sets “TARGET” rate for FFR - Uses OMO to adjust MS to adjust FFR “at or

near target”

a) How does this affect the you, me, and the rest of the economy?

Use of OMO and FFR……. “sets off a chain of events…..”

• 5 (bottom left column)

a) Expansionary Monetary Policyi. FOMC buys securitiesii. Increase MSiii. Decrease FFR…….which leads to iv. Increase banks lending and borrowing….leads to..v. Increase willingness of banks to let you borrow at

lower rates ….which leads to vi. Decrease in other interest rates throughout the

economyvii. Increase in MSviii. Increase spending

• 6. Discount Rate • Banks borrow directly from Fed• Least powerful of 3 tools – but a change in DR

does signal a change and can create a desired reaction

• Lower DR……..• Lower other IR….increase MS

7. Reserve Requirement- Most powerful ; least used- Expansionary = lower RR